Author: JW Mason

Substitution and Allometry

Brad DeLong channels Milton Friedman:

Supply and demand curves are never horizontal. They are never vertical. If somebody says that quantities change without changing prices, or that prices change without changing quantities, hold tightly onto your wallet–there is something funny going on.

Yes, this is how economists think, or at least think they think. And there’s more than a bit of truth in it. Certainly in the case at hand, DeLong-cum-Friedman is right, and Myron Scholes is wrong: It’s neither plausible nor properly thinking like an economist to suppose that if unconventional monetary policy can substantially reduce the quantity of risky financial assets held by the public, the price of such assets — the relevant interest rates — will remain unchanged.

That’s right. But it’s not the only way to be right.

Consider the marginal propensity to consume, that workhorse of practical macroeconomic analysis. It’s impossible to talk about the effects of changes in government spending or other demand-side shifts without it. What it says is that, in the short run at least there is a regular relationship between the level of income and the proportion of income spent on current consumption, both across households and over time. Now, of course, you can explain this relationship with a story about relative prices driving substitution between consumption now and consumption later, if you want. But this story is just tacked on, you don’t need it to observe the empirical relationship and make predictions accordingly. And more restrictive versions of the substitution story, like the permanent income hypothesis, while they do add some positive content, tend not to survive confrontations with the data. The essential point is that whatever one thinks are the underlying social or psychological processes driving consumption decisions (it’s unlikely they can be usefully described as maximizing anything) we reliably observe that when income rises, less of it goes to consumption; when it falls, more of it does.

In biology, a regular relationship between the size of an organism and the proportions of its body is called an allometry. A classic example is the skeleton of mammals, which becomes much more robust and massive relative to the size of the body as the body size increases. Economists are fond of importing concepts from harder sciences, so why not this one? After all, consumption is just one of a number of areas where we rely on stable relations between changes in aggregates and relative changes in their components. There’s fixed-coefficient production functions (strictly, an isometry rather than allometry, but we can use the term more broadly than biologists do); the stylized fact, important to (inter alia) classical Marxists, that capital-output ratios rise as output grows; or composition effects in trade, which seem to play such a major role in explaining the collapse in trade volumes during the Great Recession.

This is a way of thinking about economic shifts that doesn’t require the price-quantity links that Friedman-DeLong think are the mark of honest economics, even if you can come up with some price-signal based microfoundation for any observed allometry. It’s more the spirit of the old institutionalists, or traditional development or industrial-organization economics, which tend to take a natural historian’s view of the economy. Of course, not every change in proportion can be explained in terms of regular responses to a change in the aggregate they’re part of. Plenty of times, we should still think in terms of prices and substitution; the hard question is exactly when. But it would be an easier question to answer, if we were clearer about the alternatives.

Does the Level of the Dollar Matter?

Mike Konczal has kindly reposted my back-of-the-envelope estimate of how much a dollar devaluation would boost US demand. (Spoiler: Not much.)

I am far from an expert on international trade and exchange rates. (Or on anything else.) Maybe some real economist will see the post and explain why it’s all wrong. But until then, I’m going to continue asking why Krugman and others who claim that exchange rates are an important cause of unemployment in this country, never provide any quantitative analysis to back that opinion up.

More abstractly, one might ask: Is the time it takes for demand to respond to changes in relative prices, minus the time it takes for exchange rate changes to move relative prices, greater than the time it takes for exchange rates changes to move relative costs (or to be reversed)? Just because freshwater economists say No for a bad reason (because relative costs adjust instantly) doesn’t mean the answer isn’t actually No for a good reason.

Abject Patience

Aldous Huxley says, “The abject patience of the oppressed is perhaps the most inexplicable, as it is also the most important, fact in all history.”

I thought of that today when I came across this story, which really must be read to be believed. And if you read the fantastic work that Mike Konczal and a few other left bloggers are doing on the foreclosure crisis, it’s clear that what happened here is shocking and horrifying but not especially unusual. All over the country, people’s homes are quite simply being stolen from them by banks and other creatures from the financial sector.

But the most disturbing part isn’t the mortgage servicers evicting people from their homes with no clear title or other legal basis. It is the homeowners themselves. The “good” ones most of all.

Tina Kimmel was told by Citi, her lender, that she qualified for a trial loan modification under HAMP. Then after seven months of paying the lower amount as instructed, she was told without explanation she did not qualify and would be considered in default if she didn’t make all the back payments with interest and penalties. She paid them. Then Citi said they wouldn’t accept her money, she was being foreclosed. She kept paying. Without informing her they sold her mortgage to Carrington Mortgage Services, which told her that all they knew was she was in foreclosure and it was up to her, not Citi, to give them documentation on anything else regarding her loan. She gave it. And that while they were deciding whether to evict her, she’d have to keep paying. She paid. Next thing she heard was a sheriff’s notice on her door, announcing the house would be auctioned in three weeks. At the last minute, she paid the $13,000 — borrowed from family and friends — that Carrington was demanding for her nonexistent missed payments, and was allowed to keep her house.

She did everything the banks told her to. She’s proud of that. Shouldn’t she be ashamed?

I don’t know that much about mortgages or mortgage fraud. But one thing I do know is that the Citis and the Carringtons will keep stealing houses as long as the victims think it’s their duty to do whatever it takes to satisfy them, and to peacefully move out if they fail.

One can’t help wondering how many houses would have to end up mysteriously burned a few days after an eviction, to make the banks find loan modifications suddenly quite attractive. But instead we get Tina Kimmel, stakhanovite bill-payer.

A Bit More on China

Mike Konczal points me to this interesting piece by Walker Frost in The American Scene, on the Chinese currency peg. I asked earlier how much Chinese appreciation would boost US demand (more on that below). But there’s a prior question, which is whether an end to Chinese currency intervention would lead to appreciation at all. As Frost points out, the dollar purchases by the central bank coexist with restrictions on private investment abroad and strong incentives for FDI by foreign firms. These policies increase net capital inflows and therefore tend to raise the value of the Chinese currency; the Chinese central bank then pushes it back down with its dollar purchases. It’s far from clear which of these effects is stronger, and therefore, whether an across-the-board liberalization would lead the Chinese currency to rise against the dollar, or to fall. In short, we should see Chinese currency interventions not as part of an export-led growth strategy that requires a current-account surplus, but as part of an investment-led growth strategy that would otherwise tend to produce a current-account deficit. [1]

This is a point Anwar Shaikh has also made, when I’ve discussed this stuff with him. Don’t talk about undervaluation, he says, that implies some known free-market equilibrium exchange rate, and there isn’t one; talk about stabilization instead.

Another interesting discussion of the Chinese currency peg is in this Deutsche Bank report, which tends to confirm my skepticism about the effect of currency adjustment on US-China trade flows. They note that “RMB appreciation tends to … reduce nominal wages in the export sector,” confirming my sense that exchange rate changes don’t reliably move relative costs. And they use an estimate of -0.6 for exchange rate elasticity of Chinese exports. I don’t want to put too much weight on this number — I’m not sure how it’s derived — and they don’t give any estiamtes for US-China flows specifically; but given the well-established empirical fact that exchange-rate elasticity is unsually low for US imports, we have to conclude that the number for Chinese exports to the US is substantially lower. So if you believe the Deutsche Bank number for Chinese exports as a whole, my estimate of -0.17 for Chinese exports to the US is probably in the right ballpark. Which, again, means that even a very large Chinese appreciation would have only a trivial impact on US aggregate demand.

[1] The same goes for tariffs and other trade restrictions imposed by Latin American countries as part of import-substitution industrialization.

… and How About a Higher Yuan?

Another day, another Paul Krugman post blaming China for US unemployment. And maybe he’s right. But it would be nice to see some numbers.

On the same lines as my earlier post about the effect of dollar devaluation on aggregate demand, we can make a rough estimate of trade elasticities to calculate the effect of a Chinese revaluation.

Unfortunately, there aren’t many recent estimates of bilateral trade elasticities between the US and China. But common sense can get us quite a ways here. In recent years, US imports from China have run around 2 percent of GDP, and US exports to China a bit under 0.5 percent. So even if we assume that (1) a change in the nominal exchange rate is reflected one for one in the real exchange rate, i.e. that it doesn’t affect Chinese prices or wages at all; (2) a change in the real exchange rate is passed one for one into prices of Chinese imports in the US; (3) Chinese goods compete only with American-made goods, and not with those of other exporters; and (4) the price elasticity of US imports from China is a very high 4.0; then a 20 percent appreciation of the Chinese currency still boosts US demand by less than 1 percent of GDP.

And of course, those are all wildly optimistic assumptions. My own simple error-correction model, using 1993-2010 data on US imports from China and the relative CPI-deflated bilateral exchange rate, gives an import elasticity of just 0.17. [1] If the real figure is in that range, then a Chinese appreciation of 20 percent will reduce our imports from China by just 0.03 percent of GDP — and of course much of even that tiny demand shift will be to goods from other low-wage exporters.

I don’t claim my estimate is correct. But is it too much to ask that Krugman tell us what estimates he is using, that have convinced him that the best way to help US workers is to foment a trade war with China?

[1] This is a real exchange-rate elasticity, not a price elasticity, so it accounts for incomplete passthrough and offsetting movements in Chinese real wages. It assumes, however, that changes in the nominal exchange rate don’t affect inflation in either country; to that extent, it’s more likely an overestimate than an underestimate

How Much Would a Lower Dollar Boost Demand?

Lots of economists of the liberal Keynesian persuasion (Paul Krugman, Dean Baker, Robert Blecker [1] — very smart guys all) think dollar devaluation is an important step in getting back toward full employment in the US. But have any of them backed this up with a quantitative analysis of how much a lower dollar would raise demand for American goods?

It’s not an easy question, of course, but a first cut is not that complicated. There are four variables, two each for imports and exports: How much a given change in the dollar moves prices in the destination country (the passthrough rate), and how much demand for traded goods responds to a change in price (the price elasticity.) [2] We can’t observe these relationships directly, of course, so we have to estimate them based on historical data on trade flows and exchange rates. Once we choose values of them, it’s straightforward to calculate the effect of a given exchange rate change. And the short answer to this post’s title is, Not much.

For passthrough, estimates are quite consistent that dollar changes are passed through more or less one for one to US export prices, but considerably less to US import prices. (In other words, US exporters set prices based solely on domestic costs, but exporters to the US “price to market”.) The OECD macro model uses a value of 0.33 for import passthrough at a two-year horizon; a simple OLS regression of changes in import prices on the trade-weighted exchange rate yields basically the same value. Estimates of import price elasticity are almost always less than unity. Here are a few: Kwack et al., 0.93; Crane, Crowley and Quayyum, 0.47 to 0.63; Mann and Plück, 0.28; Marquez, 0.63 to 0.92. [3] (Studies that use the real exchange rate rather than import prices almost all find import elasticities smaller than 0.25, which also supports a passthrough rate of about one-third.) So a reasonable assumption for import price elasticity would be about 0.75; there is no support for a larger value than 1.0. Estimated export elasticities vary more widely, but most fall between 0.5 and 1.0.

So let’s use values near the midpoint of the published estimates. Let’s say import passthrough of 0.33, import price elasticity of 0.75, and export passthrough and price elasticity both of 1.0. And let’s assume initial trade flows at their average levels of the 2000s — imports of 15 percent of GDP and exports at 10.5 percent of GDP. Given those assumptions, what happens if the dollar falls by 20 percent? The answer is, US net exports increase by 1.9 percent of GDP.

1.9 percent of GDP might sound like a lot (it’s about $300 billion). But keep in mind, these are long-run elasticities — in general, it takes as much as two years for price movements to have their full effect on trade. And the fall in the dollar also can’t happen overnight, at least not without severe disruptions to financial markets. So we are talking about an annual boost to demand of somewhere between 0.5 and 1.0 percent of GDP, for two to three years. And then, of course, the stimulus ends, unless the depreciation continues indefinitely. This is less than half the size of the stimulus passed last January (altho to be fair, increased demand for tradables will certainly have a higher multiplier than the tax cuts that made up a large share of the Obama stimulus.) The employment effect woul probably be of the same magnitude — a reduction of the unemployment rate by between 0.5 and 1.0 points.

I would argue this is still an overestimate, since it ignores income effects, which are much stronger determinants of trade than exchange rates are — to the extent the US grows faster and its trading partners grow more slowly as a stronger US current account, that will tend to cancel out the initial improvement. I would also argue that the gain to US employment from this sort of rebalancing would be more than offset by the loss to our trade partners, who are much more likely to face balance of payments constraints on domestic demand.

But those are second-order issues. The real question is, why aren’t the economist calling for a lower dollar providing quantitative estimates of its effects, and explicitly stating their assumptions? Because on its face, the data suggests that an overvalued dollar plays only a modest role in US unemployment.

[1] I was going to include Peter Dorman on this list but I see that while he shares the IMO misplaced concern with global imbalances, he says, “Will a coordinated dollar devaluation do the trick? Maybe, if you can get coordination (no easy feat), but it is also possible that US capacity in tradables has deteriorated too far for price adjustment alone to succeed.” Which is a more realistic view of the matter than the one Krugman seems to hold. On the other hand, Dorman was also writing just a couple years ago about The Coming Dollar Crash. That dog that didn’t bark is something I’ll hopefully be writing about in a future post.

[2] Many studies collapse passthrough and price elasticity into a single measure of real exchange rate elasticity. While this is a standard approach — about half the published papers take it — I would argue it’s not the right one for either analytic or policy purposes. Analytically, the real exchange rate elasticity doesn’t distinguish between the behavior of buyers and sellers: A low value could mean either that consumers are not responsive to price, or that sellers are holding price stable in the face of exchange rate changes. And on the other side, it’s the nominal, not real, exchange rate that’s accessible to policy. Policy-induced movements in the nominal exchange rate only translate into movements in the real rate if we assume that price levels (and real wages, if we’re deflating by labor costs) don’t respond to movements in the exchange rate, which is not generally a safe assumption.

[3] Price elasticities are all negative of course. I’m omitting the negative sign for simplicity.

Robert and Frank

Quote of the day: “Robert and Frank were like two peas in a pod — only they were like the peas in Mendel’s genetic crosses , one smooth and one wrinkled.” From an LRB review of a new biography of Frank Oppenheimer, brother of Robert, CP member, experimental (rather than theoretical) physicist, and — I had not known this; I have fond memories of my visit there when I was 12 or 13 — founder of the Exploratorium.

The reviewer was presumably thinking of Genesis 27 as well as Mendel. Certainly there’s something biblical about the Oppenheimer brothers. At Trinity, Robert famously quoted, or anyway later recalled or imagined quoting, the Upanishads: “I am become death, destroyer of worlds.” Frank recalled it differently: “I think we just said: ‘It worked.'”

Liberal : theoretical : classicist :: communist : experimental : pragmatist. Doesn’t one major axis of the 20th century lie right down that line? Frank described his job on the Manhattan Project as “training people to fix what broke, redesigning things when necessary, and ensuring that no one slacked off on the job.” Mutatis mutandis, wouldn’t most communists have described their work the same?

Disagreement with the World

There’s a very fine interview with Argentine historian Adolfo Gilly in the new New Left Review. I especially liked this:

One is led to rebellion by sentiments, not by thoughts. At the end of his statement to the Dewey Commission, Trotsky described being drawn to the workers’ quarters in Nikolayev at the age of eighteen by his “faith in reason, in truth, in human solidarity,” not by Marxism. But perhaps the most crucial sentiment is that of justice — the realization that you are not in agreement with this world. There is a story that Ernst Bloch was once asked by his supervisor, Georg Simmel, to provide a one-page summary of his thesis before Simmel would agree to work on it. A week later, Bloch obliged with one sentence: “What exists cannot be true.”

Yes. The sense that there is something radically wrong, something intolerable, about the world as it exists, is the deep spring from which the strongest political commitments flow.

(I was also interested by Gilly’s claim that in 1960, when he became involved with the Algerian struggle for independence, official Communist parties were hostile because “Moscow characterized the Algerian war of independence as a bourgeois nationalist movement which deserved no backing.” It’s certainly true that the Soviet Union was very slow to support the Algerians; but Alistair Horne argues, I think plausibly, that this was mainly because they wanted to build on a their good relationship with De Gaulle’s France, and also because the French CP, with its strong base among working-class pied noirs, was divided on the war; and not because of any judgment about the character of the Algerian independence movement itself. It’s characteristic — and not unappealing — that a Trotskyist downplays these practical-political considerations and instead sees a difference of ideology.)

Wind, Rising

Here’s an interesting datapoint: According to the US Energy Information Agency, fully 50 percent of the net new electricity generation capacity added in 2008, was from wind power. (8,300 megawatts of a total of 19,000 megawatts of new capacity; but 2,600 megwatss worth of fossil-fuel capacity was retired.) This is very exciting; it’s clear that, despite some truly foolish opposition (what’s wrong with those people? wind turbines are beautiful), wind power has reached takeoff as a commercially viable industry.

If we are going to preserve a habitable planet, a big challenge is threading the line between complacency and despair. So it’s important to balance the bad news about the scope of the problem, with good news about its solvability.

(If you want to bend the stick back the other way, you could pick up James Hansen’s Storms of My Grandchildren and read the chapter on the Venus syndrome. Terrifying.)